Reasons For Rational Optimism For Investors: Earnings And Strong Economic Growth
I wanted to share some great news for long-term investors.
The market is rocketing higher after what Bloomberg calls a “Goldilocks” jobs report.
The jobs report points to a strong economy, but not too strong. The Fed is now expected to be able to cut rates in September and December, plus potentially end QT (reverse money printing) by year-end.
Following the jobs report, Moody’s chief economist, Mark Zandi, told Bloomberg that he sees the data consistent with a soft landing, two rate hikes this year, and most importantly, “at least 2.5% GDP growth this year, just like last year.”
The Mag 7 is delivering the goods regarding earnings growth this year, just like last year. And there’s even more good news.
Notice how the S&P 493 has had earnings growth. That’s the mirror image of the Mag 7.
In 2022, the earnings recession hit big tech first, then a massive recovery of 31% in 2023 and 29% in 2024.
- 2025 consensus: 16% EPS growth
- 2026 consensus: 15% EPS growth
- Morningstar’s 5-year EPS growth forecast: 15%
The earnings recession for the rest of the market, the S&P 493, was in 2023, with a modest recovery in 2024 but an accelerating growth rate on earnings.
Reasons For Optimism In 2024 And 2025
The market is forward-looking, usually 12 months out.
As the Fed starts cutting rates, the potential for up to $1 trillion to flow into high-yield (value) blue chips creates a sizeable potential tailwind for value.
Meanwhile, that rally, powered by 17% EPS growth, would be completely justified by fundamentals.
And guess what?
The bond market thinks the Fed will cut about 1% in total through 2026. Fed monetary policy takes two years to work its way through the economy.
What does all this mean?
Moody’s thinks “at least 2.5% GDP growth in 2024”.
According to the Congressional Budget Office, there will be strong tailwind effects from the Fed and immigration into 2025 (from 2023 and 2024 labor force growth).
We have ongoing investments from the IRA, CHIPS Act, and the $1.25 trillion infrastructure bill passed years ago.
The Fed expects to cut slowly but steadily through the end of 2026 implying monetary tailwinds for the economy through the end of 2028.
By 2026 or 2027, the productivity boost from AI is estimated to increase from 0.3% to 2.9% per year. Extra productivity to as much as 6.2% productivity growth, according to McKenzie (5% base-case), which is likely to be showing up in the economy.
Even Goldman’s 1.5% productivity boost base case would represent 3.1% total productivity. According to JPMorgan and Bank of America, that means something for the US economy.
- 3.4% base-case GDP growth (as high as 7.2% potentially)
- 9% faster corporate profit growth for S&P
- 17% to 22% long-term EPS growth for S&P
- 18.5% to 23.5% CAGR total returns for the S&P
In other words, the short-term outlook for the economy is good, the long term is stronger, and the bullish case, such as McKenzie’s 5.3% GDP growth base case, is truly spectacular.
5.3% GDP growth translates to about 30% EPS growth for the S&P (even more for the Mag 7).
Such growth would fully justify 31.5% Annual Total Returns if it materializes.
For context, 31.5% annual returns for five years would be a 293% fundamentally justified rally, almost 4X returns for investors.
Always And Forever A Market Of Stocks, Not A Stock Market
There are many rational, data-driven reasons to be bullish on stocks in the short, medium, and long term.
But as we just saw, the Mag 7 drives all earnings growth today.
This showcases the dispersion between the market’s winners and everyone else.
My research team recently brought me a list of companies trading at 52-week lows, and today, I want to explore two interesting ones: CVS (CVS) and Humana (HUM).
These blue-chip industry giants are down 40% off record highs, even with the market rallying strongly.
So, let’s consider why Wall Street hates CVS and HUM and whether you should consider buying them.
Risk Section Upfront
As Charlie Munger said, “Invert, always invert.”
Even the most legendary dividend aristocrats can fail, as seen with several beloved aristocrats in the last few years.
- AT&T (T) – failed aristocrat
- Walgreens (WBA) – failed aristocrat
- 3M (MMM) – failed dividend king
- Leggett & Platt (LEG) – failed dividend king
- V.F. Corp. (VFC) – failed dividend king
Business is hard, and companies always try to steal market share, outcompete each other, and disrupt industries.
The past is history, the future is a mystery, the present is a gift.” – Alice Morse Earle
My analysis is based on the past, present, and FactSet consensus future. I’ve spent 11 years building a comprehensive safety, quality, valuation, and risk management model.
But my recommendations and company reviews are always “snapshots in time.”
When the facts change, I change my mind. What do you do sir?” – John Maynard Keynes
As we’ve seen recently, the facts can change rapidly, with CVS and Starbucks (SBUX) crashing as much as 20% in a single day (3rd worst day in SBUX history).
So, let’s consider whether it’s time for long-term investors to run for the hills for SBUX, CVS, and HUM or whether it’s “greedy when others are fearful.”
Why CVS Isn’t Likely To Be The Next Walgreens
CVS and Walgreens have struggled with the rise of digital retail, and they have two different strategies for pivoting.
Walgreens was conservative, sticking to its knitting and focusing on retail, which didn’t work out. The higher inflation post-pandemic, along with the tightest job market in over 50 years and the continued strength of digital retail, including Amazon (AMZN), crushed its dividend. The highest rates in 20 years combined with its large debt pile ended a 46-year dividend growth streak.
CVS, in contrast, chose to diversify and become a vertically integrated healthcare services company. CVS built its empire through smart M&A; those big, bold deals usually worked well for investors.
In 2018, CVS announced it was buying health insurance giant Aetna for $69 billion, the largest deal in its history. It ended decades of impressive 9% dividend growth by focusing on de-leveraging its balance sheet and integrating Aetna into a holistic healthcare empire. That includes everything from Minute Clinics to health insurance to drug delivery through the mail.
Management’s long-term growth guidance at the time of the Aetna deal was 9% to 11%, consistent with its 20-year average.
Bottom-Line Upfront: CVS Is A Bargain, Not Likely The Next Walgreens
5-Year Consensus Total Return Potential
3-Year Consensus Total Return Potential
CVS is expected to recover from a terrible earnings year with back-to-back 11% EPS growth in 2025 and 2026.
That means there is likely potential to double in three years and almost triple in the next five years, assuming it delivers on these more conservative post-earnings estimates.
Why CVS Fell Off A Cliff
In April, the Center for Medicare and Medicaid Services announced lower-than-expected rates for Medicare Advantage, which hit companies like Humana.
Aetna’s Medicare Advantage profits fell hard this quarter because of lower revenue and higher utilization rates.
The reason for that is inflation. Medical costs are rising, and of course, despite the rise of GLP1 drugs in recent years, US healthcare trends continue to deteriorate, at least for now.
In 2023, Medicare Advantage rate policies were mispriced due to the Pandemic/War inflation spike, which no health insurance company could know.
CVS is also facing a perfect storm because in 2022, Centene, one of the largest managed care companies in America (an intermediary between private companies and the US government), awarded a $35 billion contract to Cigna instead of CVS.
The loss of that contract is deepening the revenue hit that is pressing on margins and is expected to now result in a 20% EPS decline this year.
However, here’s the good news for CVS and high-yield, deep-value investors.
The 5% Yield Appears Low Risk
CVS remains slightly leveraged at 3.5X debt/EBITDA, though it is expected to keep drifting lower.
S&P rates CVS at BBB stable, a 7.5% 30-year bankruptcy risk.
The bond market, via credit default swaps, estimates about 2.7% 30-year bankruptcy risk. The risk of default, up about 30% in recent weeks, is still relatively low at 0.5705% in the next three years.
Note that the 5-year default risk has increased only a little while the stock price has decreased significantly, indicating a likely overreaction by investors.
CVS has well-staggered bond maturities and will likely be able to refinance at reasonable rates. The company sold 40-year bonds in 2023 at a 6% yield, which still trades at 6.22% today.
The “smart money” on Wall Street, bond investors, have enough confidence in CVS and that it’s not the next Walgreens that they are willing to lend to the company for 39 more years at reasonable rates.
That’s because free cash flow is expected to recover by 2025, hit new record levels, and grow to almost $14 billion by 2028.
40% is the safe FCF payout ratio rating agencies like to see, and CVS’s FCF payout ratio, even factoring in a modest free cash flow decline in 2024, is expected to peak at 37%.
- 2024 FCF payout ratio consensus: 37%
- 2025: 31%
- 2026: 35%
That’s why analysts expect accelerating buybacks as well as growing dividends.
CVS’s dividend is expected to grow about 6% annually through 2026 as the company keeps deleveraging.
CVS is now trading at about 7.5X forward earnings and about 13X enterprise value/FCF (the #1 valuation metric of the last 33 years).
The yield on cost by 2026 is expected to grow to 5.2%.
CVS appears to be an extremely undervalued and attractive deep-value opportunity for anyone who trusts that this management team will be able to deliver on its long-term guidance.
Humana: Is this time different for insurance companies?
Humana has been down 40% last year because it’s the most concentrated Medicare Advantage insurance company.
This Appears To Be A Good Buying Opportunity, But Not As Good As CVS
Humana beat expectations recently, but it pulled 2025 guidance back in April and said it won’t provide new 2025 guidance until early 2025.
Analysts expect almost 30% annual EPS recoveries in 2025 and 2026 from a nearly 40% decline in 2024.
That could change, of course.
I don’t expect HUM to grow only 4% in the long term (the FactSet median consensus is 5%).
You can see how the growth outlook can be volatile.
That being said, I understand how, with a 1.1% yield, such a small growth outlook might not be attractive for value investors, especially when CVS offers almost 5%.
Might the government screw Humana again next year? Regulatory risk is certainly the largest risk for Humana. However, we have to keep several things in mind.
Fact 1: Major regulatory changes are not likely anytime soon.
Political experts such as 538 and Cook Political Report expect a split Congress for whoever wins the Presidency in November.
The divided government makes major changes, such as the very low rate of Medicare for All (the biggest threat to insurance companies). Morningstar’s estimate for M4A in the next decade is about 5%.
For context, that’s the same level of risk as a BBB+ credit-rated company going bankrupt in the next three decades.
Fact 2: Humana has the balance sheet to survive and recover from this setback.
Humana’s BBB balance sheet has well-staggered bond maturities, and the bond market is confident enough in their future to lend to them at reasonable rates for 30 years.
Note that Humana’s longest-duration bonds were sold in April at a 5.75% yield. Today, they yield 6.01%, indicating that bond investors don’t believe fundamental risk has increased significantly.
In fact, according to the credit default swap market, Humana’s fundamental risk has been down 10% in the last six months.
Bottom Line: Now Is The Time To Be Greedy When Others Are Fearful On CVS And Humana
I like CVS more than Humana, as the nearly 5% low-risk yield while we wait for the Medicare Advantage pricing effects to roll off next year provides a more certain upside.
However, both appear to be potentially attractive deep-value opportunities, classic examples of Wall Street’s overreactions.
These are not dying companies but well-managed businesses, industry leaders in industries that face regulatory risk but with major regulatory changes unlikely for the foreseeable future.
Corporate America spends $4 billion per year on lobbying, and guess which industries spend the most?
Insurance is the country’s number one lobbyist, spending over $1 billion this election cycle, or almost 25% of all lobbying. And guess what? They split their lobbying budgets 50/50 between Democrats and Republicans.
I don’t like all this lobbying, but money talks, which is why major reform in a split government is likely a low-risk threat to the health insurance industry.
What kind of long-term upside is possible in buying CVS and Humana in deep bear markets like this?
Humana and CVS have had some epic bear markets that are far worse than today’s.
And guess what the benefit of bear markets like these can do?
The Upside Of Downside: Examples Of What “Greedy When Others Are Fearful” Can Do
Humana’s Best Returns Courtesy of Its Worst Bear Market (1998 to 2000 -84.37%)
Time Frame (Years) | Annual Returns | Total Returns |
1 | 208% | 208% |
3 | 78% | 461% |
5 | 52% | 715% |
7 | 43% | 1149% |
10 | 29% | 1192% |
15 | 28% | 4014% |
(Source: Portfolio Visualizer)
Humana’s worst bear market in history was an 84% decline in just three years (Medicare changes at the time were the cause).
Those investors brave enough to buy when investors hated Humana most were able to achieve life-changing returns as high as 28% annually for the next 15 years, a 41X return.
CVS’s Best Returns Courtesy of Its Worst Bear Market (2001 to 2003 –62.37%)
Time Frame (Years) | Annual Returns | Total Returns |
1 | 76% | 76% |
3 | 65% | 351% |
5 | 38% | 393% |
7 | 23% | 315% |
10 | 18% | 427% |
15 | 15% | 733% |
(Source: Portfolio Visualizer)
While CVS and Humana may have further to fall, based on the best available data and evidence today, I believe anyone with a 5+ year time frame will be a happy buyer.
Just remember to size your positions appropriately for your risk profile.